February offered investors a glimpse of what could happen if economic conditions and policy shift slightly on their respective axes. While our returns were not spectacular in February, they were positive against a backdrop of some large falls in equities (while global equities declined around 3.5% during the month, intra-month declines in some markets were in the order of -10%) and wider credit spreads, mainly in the high-yield space. This served as a timely reminder that risk does matter, and certainly from our perspective in managing the strategy, avoiding/mitigating drawdowns is an extremely important objective. While we acknowledge that our returns would have been better in 2017 if we’d held more equities, this is a double-edged sword. More equities are fine on the way up, but punitive on the way down, and, while we’d like to think we can time markets, the reality is we can’t. February showed what can happen.
Category Archives: Real returns
Despite a frenetic start to 2018, much of the trajectory of markets is as expected and forecasts are unchanged for the medium term. However, with indicators that core inflation is rising — particularly in the key US market — it remains to be seen how policymakers will deal with this issue, and also how it will affect investor perceptions about the prices they pay for assets.
Separately, the sovereign bond markets have had a shaky start to 2018 and while we’ll hold back on saying there’s a start of a bear market on bonds, there are two ways it could go — to blow out, or blow up. A blow out would come as gains accrue in the absence of a market shock, like inflation. A blow up could occur with anything that challenges the fundamental macro and policy support for the market, including a growth shock from China, a pick up in wages or inflation, or central banks being slow to respond to inflation.
The near euphoric sentiment evident in January was a good precursor to February’s re-pricing. The bigger risks though are fundamental, and rising inflation is a legitimate cause for caution.
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Implications of low return forecasts for Balanced Funds
The point of this note is to highlight the embedded shortfall risk in a typical fixed SAA investment strategy (e.g. the typical Australian balanced fund) should returns be low (and clustered) as we currently project.
Aggressive asset allocation within narrow ranges is also unlikely to solve the problem given the structural anchoring to equity market outcomes and the relatively narrow tactical ranges… this is an inherent structural flaw within the SAA model.
The practical implication is that this significantly limits the ability of managers of these types of portfolios to “turn the dial” sufficiently in an environment of compressed and clustered returns or where equity returns are moderate.
It is widely acknowledged that the outlook for economies and investment markets is unusually uncertain, given the huge political changes that we are witnessing across the world. It is also widely acknowledged that most assets are expensive and most likely are priced to offer sub-normal prospective returns. Why then is volatility (the VIX) so low? History tells us that periods of crisis are often preceded by periods of abnormally low volatility and complacency about risk and valuations. Are we in one such period?
In contrast to what is a relatively benign macro outlook, the starting point for key markets is more problematic. Thus achieving high real rates of return by simply hoping for strong underlying market performance would be optimistic.